Working Paper: NBER ID: w21476
Authors: James D. Hamilton; Ethan S. Harris; Jan Hatzius; Kenneth D. West
Abstract: We examine the behavior, determinants, and implications of the equilibrium level of the real federal funds rate, defined as the rate consistent with full employment and stable inflation in the medium term. We draw three main conclusions. First, the uncertainty around the equilibrium rate is large, and its relationship with trend GDP growth much more tenuous than widely believed. Our narrative and econometric analysis using cross-country data and going back to the 19th Century supports a wide range of plausible central estimates for the current level of the equilibrium rate, from a little over 0% to the pre-crisis consensus of 2%. Second, despite this uncertainty, we are skeptical of the “secular stagnation” view that the equilibrium rate will remain near zero for many years to come. The evidence for secular stagnation before the 2008 crisis is weak, and the disappointing post-2008 recovery is better explained by protracted but ultimately temporary headwinds from the housing supply overhang, household and bank deleveraging, and fiscal retrenchment. Once these headwinds had abated by early 2014, US growth did in fact accelerate to a pace well above potential. Third, the uncertainty around the equilibrium rate implies that a monetary policy rule with more inertia than implied by standard versions of the Taylor rule could be associated with smaller deviations of output and inflation from the Fed’s objectives. Our simulations using the Fed staff’s FRB/US model show that explicit recognition of this uncertainty results in a later but steeper normalization path for the funds rate compared with the median “dot” in the FOMC’s Summary of Economic Projections.
Keywords: equilibrium real funds rate; monetary policy; secular stagnation; trend growth
JEL Codes: E32; E43; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Uncertainty around the equilibrium rate (E43) | skepticism about the secular stagnation hypothesis (E19) |
| Post-2008 growth stagnation (O49) | temporary headwinds (E32) |
| Dissipation of headwinds (G19) | US growth acceleration (O49) |
| Recognition of uncertainty in the equilibrium rate (D59) | normalization path of the funds rate (E43) |
| Equilibrium rate (D53) | personal discount rates (H43) |
| Equilibrium rate (D53) | financial regulation (G18) |
| Equilibrium rate (D53) | inflation trends (E31) |
| Equilibrium rate (D53) | trend growth (O41) |